Never let your heart rule your head

Avoid unhappy investments with a 'pre-nuptial agreement' for shares

Falling in love is wonderful. It lets the sun shine on rainy days and brings real meaning to such words as joy, happiness and contentment. But beware, love is blind. It ignores blemishes and forgives faults. So my message to the private investor is simple: never fall in love. For the avoidance of doubt, I will exclude human relationships from that statement.

Falling in love is wonderful. It lets the sun shine on rainy days and brings real meaning to such words as joy, happiness and contentment. But beware, love is blind. It ignores blemishes and forgives faults. So my message to the private investor is simple: never fall in love. For the avoidance of doubt, I will exclude human relationships from that statement.

But when it comes to investing you must avoid letting your heart rule your head. One way of doing this is to adopt a "run-profits and stop-losses" policy which Chris Ring, managing director of NatWest Stockbrokers, alluded to when I interviewed him a couple of weeks ago. Since then several readers have asked me to expand on the system.

When you begin to fancy a share and decide to find out all about it, you are embarking on a kind of courtship that will involve a substantial amount of time, effort and thought on your part. The very fact that the share caught your eye in the first place, standing out from the crowd and saying, "C'mon, buy me", means for you this stock could be a special turn-on. Unless you are a starry-eyed beginner, in which case you will be thinking about an immediate marriage without giving a fig for the consequences, there's a lot of homework to be done.

You have to dig around, uncover past history, ask former lovers whether their liaisons with the company of your affections were satisfactory. If there have been unhappy affairs in the past, you need to know the details. You must have a long talk with those who know the company best to discover whether its past and future behaviour had been and will be acceptable to your high ideals. All this before you make up your mind whether you can live together in harmony.

Even then you can still make a mistake. Despite your best efforts, the partner of your choice - the good-looking share that captured your heart - might not perform as expected. Love dies, but what to do about it? Should you carry on and hope things will get better, or is it best to make a clean break? The only realistic answer is divorce, and to save all the heart-searching about when is the best time to irrevocably sever the relationship, I suggest you have a pre-nuptial agreement. Such legal arrangements may seem rather clinical, but if it's good enough for Michael Douglas and Catherine Zeta Jones, why not for you? In investing parlance it is called the Run-Profits-Cut-Losses Agreement, and it works thus:

When you have investigated the share you are keen on, checked its pedigree and made sure there are no nasties from the past to sully its reputation, you will be asked to pay a dowry in order to own it. That's the share price and it is the measure by which your affections will be tested. While the price continues to blossom and flourish you will make the perfect couple, happy in each other's company. That is the run-profits part.

But suppose the share price begins to wither? Then you must get out before an annoyance turns into a disaster. On the day of your marriage to the share, when you actually hand over the dowry to the stockbroker, you should set a rolling stop-loss percentage figure. It need not necessarily be the same for all your investments. If the share is a steady, reliable one with a history of gentle but persistent growth and a price which reflects that image, then choose a percentage figure of 15 or at the most 20 per cent. For more flighty shares which are considerably affected by market volatility, set your stop-loss at anything between 25 and 35 per cent.

Now let me emphasise a most important point. The stop-loss figure remains constant but moves with the share price.

Here's an example: You buy shares in Heartsaflutter Company at £2 each. It's a good business with a five-year record of steadily improving earnings growth for both the company and its shareholders, and the experts are forecasting the pattern of profit will be repeated in the foreseeable future. In recent years the share price has risen evenly and you believe this uniform increase will continue. You set your stop-loss at 20 per cent, which in this case means if the price drops to £1.60 you sell the share. No arguments. Get rid of it.

But let's look on the bright side and suppose the price does what you hoped it would do, it goes up. £2.50 ... £2.75 ... £3. Excellent, what a good judge you are. Hang on though, wait a cotton pickin' minute, the price is going down! £2.80 ... £2.60 ... £2.40. That's the stop-loss, a 20 per cent fall, 60p off its high of £3. Sell, sell, sell. Be thankful that you have made 40p on every Heartsaflutter share you bought. You made a 20 per cent gain on your money.

Of course this run-profits-stop-losses system is not an exact science. There will be times when you could kick yourself for having sold, because no sooner have you cashed in then the share starts to go up again. Equally, because the price fall was dramatic and you didn't know about it until too late, the price has fallen way below your 20 per cent stop-loss figure. Don't worry, sell anyway and resolve to check on your portfolio more often in future.

There are variations on the system that you may care to consider. One I particularly like is to set a "take-profits" figure when you buy the share. At the time of purchase, establish a reasonable percentage profit which you would like to see. Let's be generous and say 50 per cent from the purchase price. When that point is reached you sell half your holding, ensuring that if, in the future, the stop-loss is breached you will still have made excellent profits.

If you have a special belief in a particular share and it falls below your stop-loss limit, you might also consider having a buy-back policy. You must sell when the stop-loss barrier is broken, but if and when the share eventually starts to bounce back you repurchase it when its price has gone up by, say, 15 per cent from its low.

Let me reiterate the run-profits-stop-losses system is not an infallible palliative, but it does have the merit of introducing a discipline into the relationship between you and your shares. And, as we all know, discipline is essential in any marriage.

* terry.bond@hemscott.net